Great rotation or great gyration

The so-called “great rotation" out of bonds and back to equities will be a gradual one, tempered by bond buying from central banks and the potential for equity enthusiasm to be dampened if more risks flare.

Strategists have argued that low global interest rates and falling bond prices have increased the attraction of equities as the economic growth backdrop brightens, emboldening investors to seek higher returns.

But Principal Global Investors Australia chief executive Grant Forster said the stronger flows into equities still paled in comparison to the money which had been pulled from the sharemarket over the course of the financial crisis.

“The flows are still small relative to the last 10 years and we are not ready to say it’s all steam ahead for equities," he said.

“Investors are still hurting after years of pain, so while we think equities will outperform bonds, investor sentiment still isn’t there."

Evidence does point to a renewed appetite for equities – the S&P 500 has hit several fresh five-year highs since January and US stock funds attracted $US21 billion in the first four weeks of 2013, according to mutual fund researcher Lipper.

This was the largest inflow for any four-week period since April 2000 but only an early sign of a turnaround, a strong preference for bond funds still evident as recently as December.

Mr Forster however pointed out that the rotation was not a simple one and switching also happening within asset classes such as bonds, investors moving from sovereign debt to corporate and emerging market debt, while equity investors were moving from large-cap, high-yield stocks to mid cap prospects.

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BlackRock’s head of fixed income Stephen Miller said bond yields in core markets remained near 50 or 60-year lows making it difficult to argue against better returns on offer in equities.

“But I do not see a wholesale sell-off in bonds because major central banks won’t suddenly stop QE [bond buying] so bond yields can’t react as they might have if unfettered by financial market oppression," he said.

“It means any upward movement in bond yields [and a corresponding fall in prices] will be a slow grinding one," Mr Miller said, contrasting the situation to the sharp jump in bond yields after the 1990’s recession.

Citigroup’s US-based analyst William Katz cautioned about making an early call on the “great rotation" back to equities, noting a slowing level of flows towards equities while interest in fixed income remained solid.

“Given the typical January strength [in markets] we continue to believe the next few weeks and months will prove more conclusive around a ‘great rotation’," he told clients.

Citi and FactSet data showed $US8.2 billion of equity inflows for the final week of January against $US3.5 billion of flows to fixed income. Yet data as recent as last November also showed British pension funds held more bonds than equities for the first time in more than 50 years.

Deutsche Bank’s Australian equity strategist, Tim Baker, pointed to the risks of backing equities too strongly, saying markets were already pricing in a growth pick-up when data was no longer positive.

“US data is now surprising negatively [such as factory orders and soft December GDP] at the same time that equity market sentiment is very high," he told clients.

About $US600 billion of tax and spending cuts were delayed by the US earlier this year – a problem which will have to be negotiated next month.

Locally, Mr Baker also warned of near-term downside for the S&P/ASX200 given the lack of an obvious earnings bounce.

Nomura’s fixed-income strategist, George Goncalves, said cash was more likely to be carefully deployed across asset classes as valuations in equities, currencies and Treasury inflation-protected securities became stretched.